How to escape the next lost decade

I can’t tell you what stocks or stock markets will perform best over the next ten years. But I can tell you that many U.S. investors are still sitting in portfolios that increase the odds that the next ten years will be as unrewarding as the last ten.

The last ten years have been really, really painful for investors in U.S. stocks.

It you had invested in the U.S. Standard & Poor’s 500 stock index in October 1999 by October 31, 2009 you would be looking at an average annual compounded return of a negative 0.95%. Lock your money up in stocks for 10 years and lose 1% a year. It’s not supposed to work that way.

And, of course, it didn’t have to.

If you had invested in China 10 years ago, say by buying Matthews China (MCHFX), one of them ol’ fashioned mutual funds (Remember them?), you would have seen an average annual compounded return of 18.17% for each of those ten years.

Object, rightly, that no one knew that China would be the investment story of the decade way back then? Well, let’s say that instead of using your amazing powers of 20/20 hindsight, you had simply bought into a mutual fund way back then that invested in all of what we still quaintly called emerging markets. The T. Rowe Price Emerging Markets Stock Fund (PRMSX). Your average annual compounded return then for that 10-year period would have been 12.06%.

Ready to make grown investors cry?

At the end of 10 years, a $10,000 investment in the Standard & Poor’s 500 was down to $9090.52.

At the end of 10 years, a $10,000 investment in Matthews China had grown to $53,097.29.

At the end of 10 years, a $10,000 investment in T. Rowe Price Emerging Markets had grown to $31,225.27.

And you know what’s even worse? Ten years ago the convention wisdom preached diversifying a stock portfolio by putting a hunk of money into overseas markets and a piece of that into emerging markets.

If an investor had simply followed the prevailing common wisdom 10 years ago and put 10% of the money in portfolio that was allocated to stocks into emerging stock markets, instead of seeing $10,000 shrink to $9091 over ten years, this investor would have seen $10,000 grow into $10,357.53. That’s a not so hot 0.35% average annual compounded return.

But a gain is always better than a loss and getting a $1,267 swing to the good on a $10,000 investment just from making one easy-as-falling-off-a-log asset allocation decision is a pretty decent return.

Anybody who doesn’t think $1,267 isn’t real money is welcome to send it to me.

Investors can’t go back in time and re-do the their under-exposure to overseas stocks in general and emerging markets stocks in particular, but sure can try not to make the same mistake in the next ten years that they made in the last ten.

All the evidence, though, is that U.S. investors are about to do it to themselves again.

The U.S. share of the global stock market is falling as other countries built larger economies and deeper capital markets. In 2004, U.S. capital markets accounted for 53% of the value of all shares in the world that were free to trade, according to Standard & Poor’s. (Many shares in markets such as China and India are locked up under government control and aren’t free to trade.) By 2007 that percentage was down to 44% and by 2008 it had fallen to 41%.

Asset allocation by U.S. investors hasn’t kept pace with that change. Depending on what group of investors you measure U.S. investors have somewhere between 2% and 20% of their equity portfolios in overseas stocks. Among 401(K) investors, about 12% of their stock portfolios are in foreign stocks.

If you simply look at the makeup of world equity markets, U.S. investors are massively over-weighted U.S. stocks and massively underweighted foreign stocks.

That might not be so devastating to the portfolios of U.S. investors if the U.S. economy was projected to outperform the economies of the rest of the world. But it’s not. The Organization for Economic Cooperation and Development (OECD) projects that the U.S. economy will grow by 2.5% in 2010 and 2.8% in 2011. China, in comparison, will grow by a projected 10.2% in 2010 and 9.3% in 2011. For India, forecasts read 7.3% growth in 2010 and 7.6% growth in 2011. Brazil 4.8% growth in 2010 and 4.5% growth in 2011.

But not all the world is projected to grow faster than the United States. Japan and Europe will in fact lag the U.S. economy, according to the OECD. The Euro Zone economies will grow by just 0.9% in 2010 and 1.7% in 2011. Japan at 1.8% in 2010 and 2% in 2011.

The out performance in China, Brazil, India and the rest of the developing world isn’t projected as a one or two year thing either. It should last for a decade or more powered by the younger populations, the faster growing productivity, and the lower post-financial crisis debt burdens of these countries in comparison to their developed market counterparts.

What you should do to avoid a repeat of the last lost decade is obvious, although it undoubtedly feels extremely daunting.

You should gradually work to increase your allocation toward overseas stocks, with an emphasis on the equities of the world’s fastest growing economies, toward something like the actual weighting of global capital markets.

There are lots of reasons that feels hard. I’ve been working for the last five years or so in my own portfolio to achieve an allocation like that and I’m not there yet. Let me tell you from experience why it feels so hard and tell you about the strategies that I’m using to get over past those difficulties.

Obstacle #1: It feels like I’ve missed the boat. The iShares FTSE/Xinhua China 25 ETF (FXI) is u 55% year to date (as of November 18) and 103% in the last year. The iShares MSCI Brazil Index ETF (EWZ) is up 120% in 2009 (as of November 18) and 97% in the last year.

Solution #1: Remind yourself that it’s early in the ball game. Deciding not to invest in China or Brazil now is like a nineteenth century investor saying he doesn’t want to buy into the future of the United States in 1875 because he’d missed the post-Civil War boom. Wait for corrections and busts. The iShares Brazil ETF was down 54% in 2008, let’s not forget. And realize that a long-enough holding period and a strong enough performance will wipe out a lot of timing mistakes.

Obstacle #2: Who knows anything about Chinese solar companies, or Indonesian cell phone operators, or Indian banks? McDonald’s (MCD) and General Electric (GE) and Apple (AAPL) are names I know. I can go out visit a store. I own their products. And when I need information I can get it from Standard & Poor’s or my online broker or on the Internet. Try to find decent information on Telkom Indonesia (TLK)?

Solution #2: Take it slow. You don’t have to become an expert on any of these companies to invest in them thanks to the growth of actively managed mutual funds and ETFs (exchange traded funds) that follow single country indexes. Buying iShares MSCI Brazil is a great way to add Brazil to your portfolio. Owning it will—if you read poke around in the lists of the ETFs holdings out can find online—give you an entry point into learning more about individual companies. In some cases, and Brazil is one, you’ve even got a choice of ETFs that will give you an exposure to different pieces of an emerging market. For example, in my Jubak’s Picks portfolio I own the Market Vectors Brazil Small Cap ETF (BRF) to get exposure to more of the domestic consumer economy. (For more on that buy see my post on my original buy in September http://jubakpicks.com/2009/09/11/buy-market-vectors-brazil-small-cap-etf-brf/ And, of course, you can read JubakPicks.com. About 30% of my Jubak’s Picks portfolio is now in true overseas stocks and I plan to increase that percentage over time. And with the launch of a subscription global stocks portfolio in the first quarter of 2010.)

Obstacle #3: I feel like everybody is chasing the same handful of stocks and the same two or three markets. I’m worried that I’m buying in just to time to be the fool of last resort that all the early smart money can sell.

Solution #3: The emerging markets make up one constantly changing new world pecking order. If China is the next United States, and India is the next China, and Brazil is the next India (whew!), then who’s the next Brazil. At the moment I’d say Indonesia. The country shows signs of moving down the same path that Brazil started down 15 years ago. There is already an ETF—Market Vectors Indonesia ETF (IDX) but it’s less than a year old. Feel like you might be getting in on the early stages? (The Economist has run a special section this year on the potential breakthrough for the country so your won’t be such a pioneer that you can’t find any information on the country.) Another emerging economy to watch is Turkey. The iShares MSCI Turkey ETF (TUR) goes all the way back to 2008. In the case of both Indonesia and Turkey you also have the option of buying an older closed-end fund such as Turkish Investment (TKF) or Indonesia Fund (IF). And finally, in many emerging, emerging markets the dominant telecom company often makes up a huge share of the market’s capitalization and gives you a good one stock way to buy the market. In the case of Indonesia the company is Telkom Indonesia (TLK) and in Turkey Turkcel Iletisim (TKC).

I’m looking to buy one or both of these for Jubak’s Picks in 2010.

Slow and steady works best when you’re expanding an asset allocation. After all we’re just at the start of a new decade.